Govt set to boost RBS and bank capital: But how?

By Steve Slater and Myles Neligan - Analysis

LONDON (Reuters) - Confidence in Royal Bank of Scotland drained at an alarming pace this week as the prospect that Britain will pump taxpayers' money into several banks raised fears about balance sheets across the sector.

RBS, now Britain's fourth-biggest bank, was hit hardest by a collapse in brittle investor confidence, and its shares crashed 39 percent on Tuesday to add to a 20 percent tumble the day before. Rival HBOS more than halved over the two days.

The selloff began after media reports that Chancellor Alistair Darling was considering a part-nationalisation of the battered sector.

The reported plan intended to shore up balance sheets and rebuild investor and customer confidence raised concern that banks are more in need of capital than the market had thought.

Also damaging was a lack of detail, the threat that the investments of existing shareholders would be diluted and interest payable on the capital could eat into profits. "Strengthened capital positions and a guarantee to fill any wholesale funding gap would remove the risk of failure for the banks involved, but what's left for ordinary shareholders is difficult to assess," said Mark Phin, analyst at Keefe, Bruyette & Woods. Reflecting that, the cost of insuring RBS's debt fell.

European banks face similar problems. A complex takeover of Belgian-Dutch bank Fortis over the past week has added to pressure on rival Dexia and increased the prospect of more state help.

A bailout of Germany's Hypo Real Estate also raised the spectre that more state rescues are inevitable, and Iceland's government is fighting to save its banks.

By injecting capital into several banks at the same time, Britain's government wants to remove the stigma that one bank needs the funds, especially as they have already raised over 20 billion pounds ($35 billion) this year.